Posts Tagged ‘Mortgage’

On Monday, the Government Accountability Office (GAO) defended the current method for budgeting for federal lending programs, known as “credit reform.” By endorsing the status quo, GAO puts itself at odds with the Congressional Budget Office (CBO), which has championed a “fair value” alternative. The details are wonky but the stakes are big. Over a decade, federal lending support for mortgages, student loans, and the Export-Import Bank could appear $300 billion more costly under fair-value budgeting than under credit reform.

CBO is right to question the way we budget for these programs. But GAO is right that CBO’s version of fair value is the wrong solution. Instead, we need a new approach that captures the strengths of both ideas, while avoiding their flaws. I laid out that alternative in a recent report.

One reason we need a new approach is that credit reform violates fundamental principles of good budgeting, for reasons that have nothing to do with the fair value debate.

The problem

Credit reform uses present values to measure the budget impact of federal loans, recording any expected gains or losses the moment a loan is made. But the rest of the budget operates on a cash basis, recording the budget effects of tax and spending policies as they happen over time. These two approaches do not mix well together. By using present values, credit reform can make federal lending appear to mint money out of thin air. It also credits the budget today for earnings it won’t see until well beyond the official budget window.

Consider a simple example: the government lends $1,000 to a business for four years expecting a 4 percent annual return, or $40-a-year for a total of $160. To finance the loan, the government issues $1,000 in Treasury bonds that pay 1.5 percent interest. At $15 per year, interest costs total $60. Thus, the government would net $100.

How should we budget for those expected gains? One possibility would be to track cash flows, as we do for other government activities. The government lends $1,000 in year one, nets $25 in each of the four following years, and gets repaid $1,000 in year five. Its overall gain would be $100, just as it should be.

That gets the cash flows right, but the timing is ill-suited to budgeting. The upfront cost can make the loan look costly even though it actually brings in money. If Congress focused on a three-year budget window, for example, the loan would look like it costs $950 even though it actually earns $100 over its full life.

A poor solution

We can avoid that problem by eliminating the confusing lumpiness of the cash flows. Credit reform does so by calculating the net present value of the return on the loan, discounted using the government’s borrowing rate. That calculation (the second row in the table) shows an instant gain of $96 when the loan is made. (The $96 is slightly less than the $100 because of pesky technical details.)

Credit reform thus eliminates the lumpiness but at a big cost: it misleadingly claims the returns to lending happen instantly. In reality, those returns accumulate gradually over the life of the loan. In its zeal to get rid of the lumpiness bathwater, credit reform mistakenly throws out the timing baby. As a result, lending programs can look like a magic money machine.

Unlike tax increases or spending cuts, lending programs get instant credit for returns they won’t see for years, sometimes far beyond the official budget window. To take an extreme case, a 100-year loan on the above terms would score as almost $1,300 in immediate budget gains under credit reform, all before the government collects a dime in interest.

To the best of my knowledge, no other person, business, or organization budgets or accounts for loans this way (please share any counterexamples; Enron doesn’t count). Instead, they either accept the lumpiness of the cash flows or use an approach that avoids the lumpiness while reflecting the real timing of returns.

A better answer

It isn’t hard: Instead of tracking all the cash flows, we can report just the net returns on the loan. When the loan is first made, there aren’t any. In our example, the $1,000 loan exactly offsets $1,000 in borrowing to finance it. The reverse happens in year five when the loan gets paid off. In between, the government nets $25 each year: $40 in interest payments less $15 in annual financing costs.

Tracking net returns is a highly intuitive way to report the budget effects of making the loan. It would match the way we budget for tax and spending programs, and would respect the budget window.

The government can and sometimes does make money from its lending programs, but not instantly. The budget community should disavow the credit reform approach and recognize that earnings accumulate gradually over time. CBO, GAO, and budget wonks should join hands to fix this problem regardless of where they sit in the fair value debate.

Note: For more on the technical details, including how to deal with loan guarantees, how the fair value debate reappears in deciding how to measure net returns, and a second challenge in budgeting for lending programs, see my report and policy brief.

Lending programs create special challenges for federal budgeting. So special, in fact, that the Congressional Budget Office estimates their budget effects two different ways. According to official budget rules, taxpayers will earn more than $200 billion over the next decade from new student loans, mortgage guarantees, and the Export-Import Bank. According to an alternative that CBO favors, taxpayers will lose more than $100 billion.

Those competing estimates pose a $300 billion question: Which budgeting approach is best?

As I document in a new report and policy brief, the answer is neither one. Each approach tells only part of the story. Congress would be better served by a new approach that fairly reflects all the fiscal effects of lending.

Compared with what?

If lending programs perform as CBO expects, they will bring in new money that the government can use to reduce the deficit, increase spending, or cut taxes. In that sense, taxpayers may come out more than $200 billion ahead.

But these programs do not fully compensate taxpayers for their financial risk. If the government took the same risk by making loans and guarantees at fair market rates—perhaps by investing in publicly traded bonds—taxpayers would make much more. Taxpayers are subsidizing the students, homeowners, and companies that borrow through these programs. In that sense, taxpayers come out more than $100 billion behind.

The same issue can arise in personal life. Suppose your aunt asks for a $10,000 loan to start a business. You’ve got exactly that much in a government bond fund earning 2.5 percent, and she offers to pay 5 percent. She’s got a good head for business, so the risk of default is very low; realistically you expect a 4 percent annual return.

The loan sounds like a winner, right? Her 4 percent beats the bond fund’s 2.5 percent, if you can handle the risk. But there’s one other thing: your brother-in-law, equally good at business, would like a similar loan, and he’s willing to pay 6 percent, with an expected net of 5 percent.

Now the loan to your aunt sounds like a loser. Your brother-in-law’s 5 percent beats her 4 percent. You might still prefer to lend to her, but you would come out behind in financial terms.

The competing CBO estimates reflect this dichotomy. One approach compares the financial returns of lending with doing nothing (the $200 billion gain in CBO’s case, 4 percent versus 2.5 percent in yours). The other compares the returns with taking similar risks and being fully compensated (the $100 billion loss in CBO’s case, 4 percent versus 5 percent in yours).

Both comparisons provide useful information. If you want to predict the government’s future fiscal condition, you should compare the financial returns of lending with doing nothing. If you want to measure the subsidies given to borrowers, you should compare returns with the fair market alternative.

When you discuss your aunt’s proposal with your spouse, you would be wise to mention not only the potential financial gain (“4 percent is better than 2.5 percent”) but the subsidy to your aunt (“4 percent is less than the 5 percent your brother would pay”). Only then can you have an open discussion of your family’s financial priorities.

Today’s approaches

The same information is necessary for an open discussion of federal budgeting. But official budget rules, created by the Federal Credit Reform Act of 1990 (FCRA), require CBO to use just the first approach in its budget analyses. Official estimates thus measure the fiscal effects of lending, not the subsidies provided to borrowers. CBO rightly believes, however, that policy deliberations are incomplete without measuring the subsidies, which CBO calculates separately using an approach known as fair value.

Policy analysts have vigorously debated the pros and cons of FCRA and fair value for years. Neither side has scored a decisive win for a simple reason: both approaches are incomplete. Fair value measures subsidies well, but tells us nothing about fiscal effects; this is its missing-money problem. FCRA measures lifetime fiscal effects well, but tells us nothing about subsidies.

By recording expected fiscal gains the moment a loan is made, moreover, FCRA makes lending appear to be a magic money machine. Lending may pay off over time, but the gains do not happen the moment the loan’s ink is dry. Like any lender, the government must be patient to earn those returns. It must hold the loan, perhaps for many years, and bear the associated financial risk.

A better approach

For those reasons, I believe we should replace both approaches with a more accurate budgeting method, which I call expected returns. As the report and brief describe, the expected-returns approach forecasts the fiscal effects of a loan by projecting the government’s expected returns year by year, rather than collapsing them into a single value at the time the loan is made, as both FCRA and fair value do.

Expected returns accurately tracks the fiscal effects of lending over time, thus avoiding both fair value’s missing-money problem and FCRA’s magic-money-machine problem. It also provides a natural framework for reporting the fiscal effects of lending and the subsidies to borrowers. Expected returns would give policymakers and the public a more accurate assessment of federal lending than either of the approaches we use now.

Yesterday, the Federal Reserve confirmed that it would end new purchases of Treasury bonds and mortgage-backed securities (MBS)—what’s known as quantitative easing—in October. In response, the media are heralding the end of the Fed’s stimulus:

What the Fed is about to do is stop increasing the amount of stimulus it provides. For the mathematically inclined, it’s the first derivative of stimulus that is going to zero, not stimulus itself. For the analogy-inclined, it’s as though the Fed had announced (in more normal times) that it would stop cutting interest rates. New stimulus is ending, not the stimulus that’s already in place.

The Federal Reserve has piled up more than $4 trillion in long-term Treasuries and MBS, thus forcing investors to move into other assets. There’s great debate about how much stimulus that provides. But whatever it is, it will persist after the Fed stops adding to its holdings.

P.S. I have just espoused what is known as the “stock” view of quantitative easing, i.e., that it’s the stock of assets owned by the Fed that matters. A competing “flow” view holds that it’s the pace of purchases that matters. If there’s any good evidence for the “flow” view, I’d love to see it. It may be that both matter. In that case, my point still stands: the Fed will still be providing stimulus through the stock effect.

P.P.S. I wrote about this last year during the tapering debate. In the lingo of that post, the Fed is moving from quantitative easing to quantitative accommodation. To actually eliminate the stimulus, the Fed would have to move on to quantitative tightening.

Is the Federal Reserve part of the government? You might think so, but you wouldn’t know it from the way we talk about America’s debt. When it comes to the debt held by the public, for example, the Fed is just a member of the public.

That accounting reflects the Fed’s unusual independence from the rest of government. The Fed remits its profits to the U.S. Treasury each year, but is otherwise ignored when thinking about fiscal policy.

In the era of quantitative easing, that accounting warrants a second look. The Fed now owns $2 trillion in Treasury bonds and $1.5 trillion in other financial assets. Those assets, and the way the Fed finances them, could have significant budget implications.

To understand them, we’ve calculated what the federal government’s debt and financial asset positions look like when you combine the regular government with the Federal Reserve, taking care to net out the debt owned by the Fed and Treasury cash deposited at the Fed:

This consolidated view offers five insights about America’s debt situation:

1. Less long-term debt. The Fed has bought $2 trillion of Treasury debt with maturities of a year or more. As a result, $2 trillion of medium- and long-term public debt is not, in fact, held by the real public. Interest payments continue, but they cycle from the Treasury to the Fed and then back again when the Fed remits its profits to Treasury. (This debt would become fully public again if the Fed ever decides to sell or allows the debt to mature without replacing it.)

2. More short-term debt. The Fed needs resources to buy longer-term Treasuries, mortgage-backed securities, and other financial assets. In the early days of the crisis response, it did so by selling the short-term Treasuries it owned. But those eventually ran out. So the Fed began financing its purchases by creating new bank reserves. Those reserves now account for $2 trillion of the Fed’s $2.3 trillion in short-term borrowing, on which it currently pays 0.25 percent interest.

3. Slightly more overall debt. The official public debt currently stands at $11.9 trillion. When we add in the Fed, that figure rises to $12.1 trillion. Bank reserves and other short-term Fed borrowings more than offset the Fed’s portfolio of Treasury bonds.

4. Lots more financial assets. Treasury’s financial assets now total $1.1 trillion. That figure more than doubles to $2.5 trillion when we add in the Fed’s mortgage-backed securities and other financial assets.

5. Less debt net of financial assets. The Fed adds more in financial assets than in government debt, so the debt net of financial assets falls from $10.8 trillion to $9.6 trillion. That $1.2 trillion difference reflects the power of the printing press. As America’s monetary authority, the Fed has issued $1.2 trillion in circulating currency to help finance its portfolio. That currency is technically a government liability, but it bears no interest and imposes no fiscal burden.

The Fed thus strengthens the government’s net financial position, but increases the fiscal risk of future increases in interest rates. When the Fed buys Treasuries, for example, it replaces long-term debts with very short-term ones, bank deposits. That’s been a profitable trade in recent years, with short-term interest rates near zero. But it means federal coffers will be more exposed to future hikes in short-term interest rates, if and when they occur.

In real life, economists never get elected president (sorry Larry Kotlikoff), probably with good reason.

In fiction, though, our odds are better. Jed Barlett is one of the most popular presidents ever, and a Nobel Laurate to boot.

And now the Planet Money team is offering up a new, faux candidate for 2012. His six-point plan for getting America going again — built on the suggestions of a diverse group of well-known economists — is five parts tax reform (repeal the mortgage interest deduction, repeal the tax benefit for employer-provided health insurance, eliminate the corporate income tax, institute a carbon tax, tax consumption not saving) and one part marijuana legalization.

Here’s his first campaign ad:

I don’t think President Obama, Governor Romney, or even Governor Johnson have much to fear.

Foreclosure starts are approximately two-thirds lower in the group with the highest measured level of numerical ability compared with the group with the lowest measured level. The result is robust to controlling for a broad set of sociodemographic variables and not driven by other aspects of cognitive ability or the characteristics of the mortgage contracts.

…

20 percent of the borrowers in the bottom quartile of our financial literacy index have experienced foreclosure, compared to only 5 percent of those in the top quartile. Furthermore, borrowers in the bottom quartile of the index are behind on their mortgage payments 25 percent of the time, while those in the top quartile are behind approximately 10 percent of the time.

Interestingly, this effect is not due to differences in the mortgages that borrowers selected (e.g., it’s not that the less-numerically-able chose systematically bad mortgages*) or obvious socioeconomic factors (e.g., it’s not that the less-numerically-able had lower incomes).

Instead it appears that the less-numerically-able are more likely to make financial mistakes once they have their mortgages. As the authors note, this conclusion is consistent with other studies that examine how financial literacy relates to saving and spending choices over time. All of which is further evidence of the potential benefits of better financial (and numerical) education.

* The authors note one caveat on the conclusion about mortgage terms: The survey covered “individuals between 1 and 2 years after their mortgage had been originated,” but many subprime defaults happened more quickly than that. As a result, their results don’t address whether financial literacy played a role in determining which borrowers ended up in mortgages that blew up very rapidly.

Washington is abuzz with the idea that Congress, the White House, or both may try to use unspent TARP funds as a way to promote job creation (see, e.g., this WSJ story and this WaPo story). Over the past two days, many reporters have asked me about the mechanics of this idea–can the government really use unspent TARP money this way? Here’s my best answer (given what I have learned so far).

There are two basic ways that our leaders could try to use TARP money to pay for new initiatives: through executive action or through new legislation.

Executive Action

Treasury Secretary Geithner has the ability to use TARP funds largely as he sees fit, as long as those uses are within the boundaries set out by the original legislation. As you may have noticed, the exact location of those boundaries–well, even the rough location of those boundaries–has been a topic of great debate during TARP’s existence. But the basic idea is that TARP can be used to purchase troubled assets, which the bill defines as follows:

(A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary determines promotes financial market stability; and

(B) any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress.

If our leaders want to use TARP through executive action, they will have to come up with programs that fit within these limits. Additional support for small-business financing or home mortgages could certainly be structured to fit within these parameters; indeed, TARP already has programs for both of those. It would require substantial ingenuity, however, to figure out a way to support some of the other ideas being floated (e.g., aid to local governments).

New Legislation

The second approach would be for Congress to enact legislation that would increase spending on various programs and then pay for it, at least in part, by reducing the amount of money in the TARP program.

There have already been at least two pieces of legislation that have taken this approach: